Herstatt Risk
Herstatt risk is the risk in a foreign exchange trade that one party pays the currency it sold but never receives the currency it bought, because the counterparty fails in between. The full principal amount is at stake.
Also called: FX settlement risk · foreign exchange settlement risk · cross-currency settlement risk
It is named after Bankhaus Herstatt, a Cologne bank closed by German regulators on 26 June 1974. The closure came at the end of the German business day, after Herstatt had received Deutsche Marks from its counterparties but before the corresponding US dollars were due to be paid in New York. Those counterparties had paid in full and received nothing.
The exposure exists because the two legs of a currency trade settle in different payment systems, in different time zones, and so at different times. Until the second leg arrives, the party that paid first has an unsecured claim for the whole amount. The episode led directly to the creation of the Basel Committee.
The standard protection is payment versus payment, in which each leg becomes final only if the other does. CLS provides it for the most traded currencies. Trades in currencies outside CLS, and trades settled over ordinary correspondent accounts, still carry the risk, which is why banks set settlement limits for each counterparty.
In practice
A large share of global FX turnover still settles without payment-versus-payment protection, particularly in emerging-market currencies. Using a well-known bank does not remove the exposure; the settlement method does.
Example
A payment firm sells €5 million for dollars to a liquidity provider and sends the euros at 10:00 Frankfurt time. The dollars are due when New York opens. If the provider is closed by its regulator at midday, the firm has paid €5 million and joins the list of creditors for its dollars.
Commonly confused with
| Term | How it differs |
|---|---|
| Market risk | Market risk is the chance the exchange rate moves against you, a loss of a few percent. Herstatt risk is the loss of the entire amount paid. |
See also
- Settlement RiskSettlement risk is the risk that a payment or trade does not complete as expected because a party fails to deliver what it owes, on time or at all, after its counterparty has already performed.
- Payment versus PaymentPayment versus payment (PvP) is a settlement mechanism for foreign exchange in which the final transfer of one currency happens if, and only if, the final transfer of the other currency happens too. It removes the principal risk of paying first.
- CLSCLS is the specialist institution that settles foreign exchange trades between major banks on a payment-versus-payment basis. Launched in 2002 and owned by its member banks, it settles 18 currencies and removes the risk of paying one side of a trade without receiving the other.
- Payment FinalityPayment finality is the point at which a transfer of funds becomes irrevocable and unconditional: it cannot be recalled by the sender, reversed by the system or unwound if a participant becomes insolvent. Before that point a payment is still a promise.
- NettingNetting is offsetting mutual obligations so that only the difference actually moves. Two parties that have been paying each other all day settle one payment for the net amount, which cuts both the funds transferred and the liquidity each side must hold to support them.
- Basel Committee on Banking SupervisionThe Basel Committee on Banking Supervision (BCBS) is the global standard-setter for the prudential regulation of banks. Hosted by the BIS, it writes the Basel framework on capital, liquidity and leverage that national regulators then put into law.